Wednesday, March 2, 2016

Premium increase insurance

It’s understandable that the sponsor of the proxy proposal believes Berkshire is especially threatened by climate change because we are a huge insurer, covering all sorts of risks. The sponsor may worry that property losses will skyrocket because of weather changes. And such worries might, in fact, be warranted if we wrote ten- or twenty-year policies at fixed prices. But insurance policies are customarily written for one year and repriced annually to reflect changing exposures. Increased possibilities of loss translate promptly into increased premiums. . . .

Up to now, climate change has not produced more frequent nor more costly hurricanes nor other weather-related events covered by insurance. As a consequence, U.S. super-cat rates have fallen steadily in recent years, which is why we have backed away from that business. If super-cats become costlier and more frequent, the likely—though far from certain—effect on Berkshire’s insurance business would be to make it larger and more profitable.

As a citizen, you may understandably find climate change keeping you up nights. As a homeowner in a low-lying area, you may wish to consider moving. But when you are thinking only as a shareholder of a major insurer, climate change should not be on your list of worries.

The puzzle to me is, why doesn't Berkshire Hathaway write ten- or twenty-year policies at fixed prices? Or, better, why does it not offer a second contract, that ensures you against the event that your regular insurance will be repriced every six months? If people are worried about it, and nobody else is doing it, it would seem they could charge a huge premium.

You may say BH doesn't want the risk, but in a previous letter Buffett explained that BH was selling 99 year put options. And being hugely diversified is precisely what allows a company like this to take some risk.

If it doesn't want to hold the risk it could sell it. Surely there are lots of investors who are skeptics of climate change -- not warming, but the claim that warming will give rise to more extreme weather and higher insurance payouts; people who cheered at that quote in the WSG -- and would be happy to put their money where their mouths are in the reinsurance market.

15 comments:

As someone who's worked in insurance, i can tell that these policies don't exist because there is not enough variability in perceived value of the insurance contract. Insurance is about helping Peter (who overvalues the insurance) pay Paul (who undervalues it) and taking a spread in the middle. If there is no Paul or Peter and Paul agree on the value then there can be no insurance.

Writing premium insurance is clearly very different than long-term insurance policies because one is never on the hook for a claim on the insurance itself, which will be a much more volatile stream than the changes in the premium stream. That said, I suspect the problem with premium insurance is the fact that capacity varies in the insurance market such that coverage is often not available at any price. Or, it's available at a higher price with more onerous terms (higher retention, reduced aggregate coverage, tighter clauses on triggers for which one might collect, etc.) So if I currently have a contract that pays me up to $5 million on losses, and it's replaced by one which is 10% more expensive, requires me to assume the first million dollars in losses and no longer covers floods, getting insurance that covers the 10 percent ain't doing much for me.

The interesting thing is premium insurance would be a good insurance cycle hedge for insurers. To the extent that they benefit from a rising premium environment (as the Oracle says), writing some premium insurance would reduce their upside in return for steady, predictable cash flows. Presumably the public markets value the smoothing of earnings streams, so this would create value.

My suspicion is the absence of this market is at least partly regulatory. Life insurance portfolios and other long tail businesses require significant dedicated capital on insurer balance sheets to ensure claims paying ability to the satisfaction of state regulators. By comparison, standard re-setting policies probably have lower regulatory capital charges. This is probably an issue even for the Berkshire's of the world (for it to matter, it would have to be big and if it's big writing lots of policies will create a large balance sheet charge).

I think 6:13 anonymous has it right. Cat insurance is an exceedingly unlikely but potentially massive payout. The capital set asides for a multi year policy might be untenable, at least for the reinsurance side. Plus the changing legislative and regulatory requirements of the future will be passed on to the insured. This may create far more uncertainty than climate change. If I charge for yesterday's regulatory regime I may be underwater tomorrow even if no great flood occurs

But the proposition is not to write multi-year insurance. The proposition is to write insurance that insures against rises in premiums -- not the event itself. Then you sell this insurance to people who think global warming is going to drive up the severity of hurricanes; you buy the reinsurance from people who think it's a crock, that premiums are going to keep going down. You take no risk personally.

John, you are correct it is a different policy type - however therein lies the rub. In the US Insurance Departments are usually quite conservative when it comes to new insurance products and concepts. As such, I'm to believe that Michael is posting CAT insurance as an example of how a Department would model the new concept. Regardless of how they would interpret it, the asymmetry in understanding never quite ends in the insurer's favor. In most cases, it's more costly to argue that there are $100 bills on the ground to be picked up than the expected benefits of picking them up.

"But the proposition is not to write multi-year insurance. The proposition is to write insurance that insures against rises in premiums -- not the event itself."

I am lost here. If the Cat insurance must be renewed every year, doesn't the Premium insurance have to cover a significantly longer period (15-30 years) to have any benefit for the purchaser? Why would anyone buy 1 year Cat insurance coupled with 1 year Premium insurance?

If that is the case, then the proposition is to write multi-year insurance.

"Then you sell this insurance to people who think global warming is going to drive up the severity of hurricanes; you buy the reinsurance from people who think it's a crock, that premiums are going to keep going down."

I will be the first to admit that I don't understand the ins and outs of the insurance industry, but...

Why would anyone sell "Premium Increase" insurance to Berkshire Hathaway when Berkshire Hathaway sets the premiums? Berkshire could invent any reason it wanted to raise premiums regardless of the weather.

Severe weather claims have increased faster than inflation in last twenty years. But the (semi-agreed-on) reason is not more powerful coastal storms, but more fragile construction on ocean front property. When people are given gov't-subsidized storm insurance, FEMA is expected to bail out, and people are fine with losing their vacation home in exchange for a big check, you have massive adverse selection that premium-rise-insurance has to price in.

Moreover, civil engineers are in a constant battle against water with win/lose tradeoffs - e.g. upstream flood prevention on the Mississippi exacerbates erosion downstream in New Orleans. The 10-20 year timeline for premium-rise-insurance also coincides with water-damage infrastructure investments - dune replenishments, levy repairs, etc are big contributors to total loss, and will change based on each community's willingness to smartly invest in their own defense - massive climate change or none at all. Again, a community promised for decades to be made whole in any event is much less likely to mount a strong defense against even normal storm level activity.

Finally, there continues to be large investment in the stereotypical "Miami beachfront hotels". Because these are rather risky from just a business standpoint (and thus discounting is high), realized Good or Bad cashflows in the first 15 years dominate years 15+ in PresentValue, so people who are implicitly shorting long-term cat risk, are actually just long a much riskier porposition in the short run (e.g. I worry more about AirBnB, and minimum wage laws when opening a hotel then 2050's sea level). But the reason people make these risky investments is the huge potential upside. For insurance carriers though, there are no homeruns; instead the game is to consistenly hit singles.

In summary, premium-rise-insurance is not a great market to short climate-change-catastrophes because it exposes you to a long tail of adverse selection, for what amounts to chump change in recurring premium.

Basically, its a premium caplet that's out of the money (because BH thinks the premium should be higher than it is today, so they wouldn't write the option at the money), which would be quite the exotic derivative. Basically, BH exposure to the events would be similar to insuring for long-term at prices they deem acceptable.

The cost of the option + the term premium (capital costs etc) for writing longer term insurance probably makes the cost FAR more for a customer.

If you're a customer, you're better off buying the cheap insurance and switching to BH rates when others are no longer competitive because they've used up their capital

Risk can be reduced through diversification or hedging. Didn't Long Term Capital Management prove that the former is sometimes nonexistent relative to estimates (diversifying across hedge bets didn't work)? Climate change is a systematic risk factor, and I don't see how it can be reliably diversified away. That leaves hedging, which matches non-homogeneous risk preferences and expectations. That puts the insurance company in the position of a market maker constructing hedged portfolios, rather than the constructor of diversified portfolios. There is nothing wrong with that, but is it practical, given the regulatory environment?

I'm gonna punt that the regulation of the insurance industry is prohibitively cumbersome. If insurance worked like a short-call there would be no caps on insurance coverage. Yet...there are almost always caps on insurance coverage, on everything from 3rd party car insurance, to health insurance. These caps are a fundamental failure of insurance to actually eliminate tail risks. Insurance, as an industry, is generally a failure.

Regulation requires that your insurance be backed by assets. And, if there's no cap on your coverage, it's not really possible for an insurance company to promise you a payout risk-free. Thus, a cap is almost always necessary.

Another reason is, of course, the positive correlation of claims for hurricanes. That makes diversification very difficult. If the premium is too high, homeowners will either take on the risk themselves or move.

A wonderful example of this is the complete inability to buy any kind of insurance for decommissioned oil-tanks. Good luck trying to reduce your exposure to EPA fines! Thousands of homeowners prefer to just leave leaks in the ground rather than try an sell the home or remove the tank and expose themselves to tail risks. Oil Tan insurance would be a perfect example of how insurance makes the world a better place. Except you can't buy it, even from the EPA.

To TOG: diversification is the idea behind a lot of insurance (the law of large numbers in the extreme), but diversifying against the risks of climate change sounds outright funny. Serious insurance companies (Allianz) are not betting against climate change, but are desperately modeling ways how to price their policies such that their premiums reflect the concomitant risks (they don't underprice). As Bob Litterman has outlined in a wonderful paper appealing to the finance crowd (CFAs and MBAs) - you do not need to agree on the exact path of the dangers to our planet and in particular to humanity of 'climate change'; all you need to agree on is: to take action to insure against an existing risk. When a home owner purchases fire insurance, is she or he sure the home will burn down? No, but the risk is large enough that it merits to ensure against it (it's not just the mortgage lender that makes that assessment, not giving a loan on a property which can go up in flames). There is another aspect to insurance (broadly associated with 'moral hazard'): once folks are insured they may act irresponsibly (in particular with second homes on the beach or on ski slopes). So much of insurance is actually forcing the insured to undertake reasonable action to prevent the house from burning down (smoke alarms and the like) in order to prevent such irresponsibility, and thus in fact make the home insurable (a calculable risk with a premium both sides can agree on, and thus are both willing to take the bet). Zoom forward to 'climate change insurance' or John Cochrane's simpler form of issuing against premium increases (longer term - otherwise what is the connection to climate change? Given 'El Ninjo' and other phenomena there are fluctuations in annual climate irrespective of 'climate change', which no climate scientist would deny). Unfortnately the big picture for insuring the climate change or let's be precise 'the global warming accompanied by more extreme weather patterns on route': this is a so-called systematic phenomenon or: the only way to insure against the risk of a depleted ozone layer generating 'human fries' on earth is to prevent it! Which insurance company will you turn to, when the GLOBAL catastrophy has happened - the insurance company agents and their guarantors also have melted down in front of your eyes. A good analogy is folks on a island without any boats or recourse to other people on the planet (more austere than the Robinson Crusoe story): they consider building a dam against flooding of the whole island. The insurance is to build a dam of a certain height and some other mitigating measures (Holland has floating houses which keep functioning during most floods). The 'premium' is the cost of doing so. Now to the question at hand: why is nobody offering insurance against the consequences of global warming? Not only is the existing 'moral hazard' or what you may call free-riding very hard and costly to keep in check via enforceable 'global contracts', i.e. insurance companies cannot force the global community to entertain risk mitigating steps of sufficient nature, on top of it your insurance company cannot pay out, once the catastrophe has happened - they are also flooded on the island (or fried under the sun, when the planet has lost its protective shield). John's advice for Warren Buffet to insure against premium increases, because he believes they are less likely than the naive climate fear community thinks: that is simply taking advantage of a temporary disagreement, which once the global climate disaster of a depleted ozone layer has happened is an irrelevant little gain (the 'winner' of this gamble has a larger boat to rest in peace on).

Continued: To worry about regulation in this context is the joke of the century - ironically regulation with 'bring it on' enforcement on a global scale may be the only means to prevent the worst case from happening. However, there is insurance of the kind John has in mind: the famous case of American Family selling 'cancer insurance' in Japan, even though the population already has health insurance. It is an unbelievably profitable product praying on the fear of some Japanese consumers from cancer (and the underwriting insurer knowing better - so far). I believe American Family is actually in the process of rolling out this insurance product for the US - 'stupid' regulation may have prevented this wonderful product from being sold here so far. Financial innovation - oh, how it lifts the sinking boats!

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About Me and This Blog

This is a blog of news, views, and commentary, from a humorous free-market point of view. After one too many rants at the dinner table, my kids called me "the grumpy economist," and hence this blog and its title.
In real life I'm a Senior Fellow of the Hoover Institution at Stanford. I was formerly a professor at the University of Chicago Booth School of Business. I'm also an adjunct scholar of the Cato Institute. I'm not really grumpy by the way!